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The chapter covers

Meaning of cost of capital

Importance of cost of capital
Classification of cost
Computation of Cost of capital
` Computation of specific cost
Cost of Debt
Cost of Preference share
Cost of Equity share
` Overall cost of capital
Meaning of Cost of Capital

The cost of capital to a firm is the minimum

return, which the suppliers of capital require.
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In other words, COC means that rate which is
paid for the use of capital.
Each source of funds has different cost,such
as cost of equity share capital, cost of
preference share capital, cost of debt, cost of
retained earning.
Meaning of Cost of Capital

From the view point of investor:- COC is

the reward for the amount he is
investing which could have otherwise
been used for consumption or for
investment at some other place.
Importance of Cost of Capital

As determination of the COC is very important

in the area of financial management :-
Capital Budgeting
Capital Structure Decision
Dividend Policy Decision
Helpful in Evaluation of financial efficiency of
Top mgt.
Helpful in comparative Analysis of various
sources of finance
Classification of Cost

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 :- refers to
the cost of individual components of capital
viz. equity share, preference
share,debentures, retained earning.

  
 refers to the
combined cost (or weighted avg COC) of the
various individual components.It is also called
the average /weighted cost of capital or
overall cost of capital.
Classification of Cost

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  Explicit
cost is the one which is attached with
the source of capital explicitly or
apparently while implicit cost is the
hidden cost which is not incurred
directly.
Example of explicit and Implicit cost

Eg. 
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if the company increase debt then investment in

the company becomes risky investors
will expect more return These increased
expectations of the investor may be considered to
be implicit cost of debt capital.
Classification of Cost

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Historial cost means the cost that has
been paid in the past for financing a
specific project.
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 is the estimated cost to be
incurred to finance a project.Future cost
is important for taking financial
decision.
Computation of Cost of Capital

It includes:-
Computation of cost of specific source of
finance.
- Cost of Debt
- Cost of Preference share capital
- Cost of Equity share capital
- Cost of Retained Earnings
Computation of weighted average cost of
capital
Cost of Debt

Debt fund can be in the form of

debentures or loans from financial
institution. Debt can be of 2 types:-
`Irredeemable or perpetual Debt
`Redeemable Debt
Cost of Irredeemable Debt

Calculation of Irredeemable Debt,

before tax :-
Kd = Int
NP where
Kd = Cost of Debt before tax
Int = Interest
NP = Net Proceeds
Example of Cost of Debt,
before tax:-
X Ltd. issues Rs 15 lakh, 8%
debentures (a) at par, (b) at a discount
of 7 % and ( c) at a premium of 10%
You are required to calculate the cost of
Debt to the company.
Cost of Irredeemable debt,
after tax
Formula:-
Kda = Int(1- t) * 100
NP
Example:- X Ltd has 8% perpetual debt of Rs
20 Lakh. The tax applicable to the company is
40%. Determine the cost of capital after tax
assuming the debt is issued (a) at par, (b) at
10% discount,and © at 10% premium
Example of Cost of
Irredeemable Debt
X Ltd.issues 40,000, 8% debentures of Rs 100
each and incurred the following
expenditure:
Underwriting Commission 2% of issue price
Brokerage 0.5% of issue price
Printing and other expense Rs 20,000
Calculate cost of Debt assuming debt is issued
At 10% premium
At 10% discount
Tax rate is 40%
Cost of Redeemable Debt

Before tax :-
Kdb = Int +1/n( RV ƛ NP ) *100
½(RV+ NP)
After tax :-
Kda = kdb X (1-t)
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A company issues Rs 5,00,000 , 10%
redeemable debentures redeemable at par
after 5 years .The cost of Floatation amount
to 4% of face value. Tax rate is 35%
You are required to calculate before tax and
after tax cost of debt if debentures are issued
at par,at a discount of 10%, at a premium of
5%
Example

A company issues 20,000, 7.5%

debentures of Rs. 100 each at a
discount of 2% t be redeemed after 10
years at a premium of 5% .The cost of
floatation amount to Rs 50,000..
Calculate cost of debt assuming tax rate
at 40%
Cost of Preference Share
Capital
2 types of Preference share capital is there:-
„ Irredeemable Preference share
„ Redeemable Preference share
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Redeemable Preference share

Formula of computing:-
Kpr = D+ (MV-NP)/ n
½ ( MV + NP )
where:-
Kpr= cost of redeemable preference
Share
D = Dividend
MV = Market value
n = no of years
Example of preference share

A company issues 10,000, 10%

preference share of Rs 100 each. Cost
of issue is Rs 2 per share. Calculate cost
of preference capital if these are issued
at par, at a premium of 10 % , at a
discount of 5%.
Example

A company issues 10,000 , 10%

preference share of Rs 100 each
redeemable after 10 years at a
premium of 5%. The cost of issue is Rs
2 per share. Calculate the cost of
preference capital.
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Is Equity Capital free of cost

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The cost is difficult to measure, as the
rate of return fluctuates every year
Its not legally binded to pay dividend to
equity share holder.
As the future earning and dividend are
expected to grow overtime.
Cost of Equity

The cost of equity can be computed with the

following methods:-
` Dividend yield method
` Dividend yield method plus growth in
dividend
` Earning yield method
` Earning yield method plus growth in earning
` CAPM Approach
á* +, 

It is also known as Dividend/ Price method.

This method is based on the assumption that
when an investor invests in the equity shares
of a company he expect to get a payment at
least equal to the rate of return prevailing in
the market.
This method is  only when the
company has stable earnings and stable
dividend policy.
Cost of Equity Share Capital

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ke = cost of equity
DPS= Dividend Per share
MP = Market Price
Example of Equity Share
Capital
Equity capital of a company consists of
5,00,000 equity shares of Rs 10 each
issued at a premium of Rs 2.5 per
share.The average rate of dividend paid
by the company has been Rs 3 per
share .The market value of the share is
Rs 25.Calculate the cost of equity
capital.
Dividend yield plus growth in
dividend method
This method takes care of the future growth in
the rate of dividend .hence, when dividend
are expected to grow at constant rate,we
compute cost by:-
Ke = DPS/ MP *100+G
Ex:- X Ltd pays a dividend of Rs 12 per share
initially and the growth in dividend is
expected to be 5 % . Compute the cost of
equity share if the current market price of an
equity share is Rs 150.
Earning Yield Method

Formula:-
Ke = EPS/ MP * 100
Example:- A company plans to incur an
expenditure of Rs 80 lakhs for expanding its
operations. The relevant operation is as
follows:-
No of existing share = 20 lakhs
Net earning = Rs 160 lakhs
Market value of existing share = 40 s
Compute the cost of equity capital.
Earning yield plus growth in
Earning Method
Formula:-
Ke= EPS/ MP *100 + G

Ex:- The current market price of the equity

share of a company is Rs 60 per share .The
expected earning per share after one year is
Rs 9 per share .Thereafter EPS is expected to
grow constantly at 4% per annum .Find out
the cost of equity capital.
Capital Assets Pricing Model or
CAPM Approach
./ 
where:-
Rf = risk free return
b = beta coeff.
Km= req return on market
return
Ex :- Calculate the cost of equity capital where the beta
factor (Risk) is 1.5. Risk free rate of interest on
Government Securities is 8% . Return on market
portfolio is 12%
The Weighted Average Cost of
Capital
We now need a general way to determine the
minimum required return
Recall that 40% of funds were from debt.
Therefore, 40% of the required return must
go to satisfy the debtholders. Similarly, 10%
should go to preferred shareholders, and
50% to common shareholders
This is a weighted-average, which can be
calculated as:
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Calculating RMMƞs WACC

Using the numbers from the RMM example,

we can calculate RMMƞs Weighted-Average
Cost of Capital (WACC) as follows:
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Finding the Weights

The weights that we use to calculate

the WACC will obviously affect the
result
Therefore, the obvious question is:
Ơwhere do the weights come from?ơ
There are two possibilities:
Book-value weights
Market-value weights
Book-value Weights

One potential source of these weights is

the firmƞs balance sheet, since it lists
the total amount of long-term debt,
preferred equity, and common equity
We can calculate the weights by simply
determining the proportion that each
source of capital is of the total capital
Book-value Weights (cont.)

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Market-value Weights

The problem with book-value weights is that

the book values are historical, not current,
values
The market recalculates the values of each
type of capital on a continuous basis.
Therefore, market values are more
appropriate
Calculation of market-value weights is very
similar to the calculation of the book-value
weights
The main difference is that we need to first
calculate the total market value (price times
quantity) of each type of capital
 Calculating the Market-value
Weights

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Market vs Book Values

It is important to note that market-values is

always preferred over book-value
The reason is that book-values represent the
historical amount of securities sold, whereas
market-values represent the current amount
of securities outstanding
For some companies, the difference can be
much more dramatic than for RMM
Finally, note that RMM should use the 10.27
WACC in its decision making process
The Costs of Capital

As we have seen, a given firm may have

more than one provider of capital, each with
its own required return
In addition to determining the weights in the
calculation of the WACC, we must determine
the individual costs of capital
To do this, we simply solve the valuation
equations for the required rates of return